Estimating Profits and Reconstructing Events with Incomplete Records

By Mitchell Chosak, CPA, CFE

Frequently in litigation and fraud engagements, accountants must make assumptions and work with incomplete records. When doing so, CPAs must be careful to make reasonable estimates based on extant records, facts, and circumstances. Subsequent conclusions and extrapolations must be conservative, nonextravagant, and fair.

Projections of revenue/profit/asset shortages and their suspected causes must be properly conceived, well constructed, and clearly presented for maximum impact. Persons responsible for those shortages and their representatives are often more conciliatory when presented with conservative findings that clearly establish the loss. Admissions or nolo contendere responses frequently follow.

The following example describes an audit for accounting improprieties regarding a series of vending machines operated by an employee club for its members. Hotline tips and employee complaints indicated skimming by the club's officers.

The available records consisted of bank statements (though some were missing), a checkbook, an activity/expenditures ledger, and an incomplete vendors' invoices file. No starting inventory figures were available. The checkbook supplied some of the information from the missing bank statements. The bank eventually furnished copies of the missing statements and cancelled checks.

The first step was to take possession of all available records. The second step was to photograph the vending machines and list their contents and sales prices.

Comparison of the item sales prices from the vending machines to their unit product costs according to vendors' invoices permitted the computation of item markup percentages. Total purchases included amounts included in the activity/expenditures ledger, checks cleared for purchases not listed in the ledger, and invoices apparently paid by cash which were neither listed in the activity/expenditures ledger nor paid by check.

The auditors ignored inventory levels on the assumption that beginning and ending levels were relatively constant. They confirmed this belief by the similar monthly purchase patterns evinced in the activity summary prepared during the examination.

The auditors then applied item markups to known purchases to arrive at expected profits. They used conservative markup percentages, allowing for spoilage and shrinkage. Expected profits were then compared to actual profits, and a significant shortage was evident.

Actual profits consisted of the excess of total sales revenue over total purchases. Auditors conducted a comparison of bank deposits to sales revenue ledger entries to determine whether an additional shortage existed between recorded revenues and funds deposited, or to reduce the profit shortage by unrecorded revenue deposited into the bank account. In this case, unrecorded revenues were deposited into the bank account.

The accompanying exhibit shows that club officers significantly underreported profits. Also, a $2,500 deposit of club funds was not recorded on the club ledger. The officers could have improperly withdrawn these funds at a later date, but the club installed new custodians as a result of the audit.

The basic principles in this example also are useful in larger or more complicated engagements. Auditors and companies investigating fraud should:

* Seize pertinent records promptly to prevent the destruction of evidence.

* Evaluate all relevant records, even if only partially available. Incomplete records usually augment each other and fill in information gaps.

* Make material assumptions if appropriate and supported by analytic procedures, such as, in this case, not considering inventory levels due to nonexistent records.

* Utilize conservative assumptions in computing shortages to lessen the amounts disputable and to avoid grandstanding. Avoid extrapolated results based on small or potentially biased samples.

* Permit the subject of the investigation an "honorable" way to admit responsibility for the loss. An air of conciliation should abound during an interrogation when the results are fair, accurate, and difficult to dispute. *

Mitchell Chosak is a member of the NYSSCPA Litigation Support Committee and a sergeant-investigator for the New York City Police Department.